There was a time when global oil prices
reflected changes in real demand and supply of crude petroleum. Of course,
as with many other primary commodities, the changes in the market could
be volatile, and so prices also fluctuated, sometimes sharply. More than
any other commodity, the global oil market was seen to reflect not only
current economic conditions and perceptions of future activity, but also
geopolitical changes and cross-currents.
Ever since the early 1970s, when group of some major oil exporting countries
OPEC, forced a three-fold increase in global oil prices its shadow has
loomed large. There is still widespread perception that the cartel of
oil-exporting countries can manipulate and influence the price by changing
the level of their own supplies. As a result, even oil-exporting countries
that are not members of the cartel have benefited from OPEC's decisions
about supply, since they have also been beneficiaries of rising oil prices.
But in fact, OPEC is more like a club of a minority of oil producers,
rather than a cartel that is in command of world oil supply. It controls
less than 40 per cent of world oil production, compared to 70 per cent
in the early 1970s. Non-OPEC countries account for increasingly significant
proportions of global supply: Russia has overtaken Saudi Arabia as the
largest supplier of crude oil since 2009. Partly as a result of this,
OPEC has recently been quite inefficient in imposing any kind of production
quota on its members, who have happily increased or decreased their production
as they wished. Most of its members are producing exactly as they would
if OPEC did not exist.
Indeed, for the past two decades, OPEC's role has generally been more
towards price stabilisation rather than pushing for increases, and it
may even have played a moderating role in oil markets, including when
particular events such as political disruptions in major exporting countries
caused sudden supply shortfalls. OPEC formerly abandoned its declared
price band in 2005, and since then has been largely powerless in determining
prices.
The argument that rising demand from China and India has determined the
upward trend in global oil prices is also unjustified. While these two
countries (and particularly China) do account for growing (but still small)
shares of global demand, these increases have been counterbalanced from
slower demand from other regions of the world, including the US and Europe.
As a consequence, on average, global oil demand has continued to grow
at between 1 and 2 per cent per annum over the past five years, usually
at a rate slightly below the annual rate of increase in global oil production.
Recent price changes in global oil markets are increasingly affected by
other forces, which have more to do with financial speculation and expectations
than with current movements in demand and supply. Chart 1 indicates the
extent of the recent rise, and shows how much it mirrors the earlier rise
in oil prices between January 2007 and June 2008.
This confirms the points made earlier about the role of other factors
in global oil markets. Clearly, this extent of price volatility – with
dramatic rise, fall and rise again within the space of three years - cannot
be the result of real demand and supply changes. Despite this, most mainstream
media persist in trying to isolate some factors affecting production in
particular locations, to account for the price changes.
The ongoing crisis in the Middle East – and particularly Libya – is generally
believed to be the impetus behind the latest spurt in prices. But Libya
produces less than 3 per cent of global petroleum output, and Saudi Arabia
(whose current excess stocks are already more than annual production in
Libya and Algeria) has already made up current shortfalls and promised
to compensate for any future shortfall. Since the unrest in the Arab region
began, there has been no significant change in global oil production,
which continues to average around 88 million barrels per day.
In any case, currently global spare oil capacity is closer to historic
highs than to historic lows. Proven reserves of oil amount to more than
40 years worth of global consumption at current levels – the highest such
ratio in the past thirty years.
The current price spike is therefore not the result of demand and supply
imbalances but is driven by uncertainty, rumour and speculative financial
activity in oil futures markets. Even in terms of expectations, Libya
is only part of the problem (and in fact oil production still continues
in many Libyan facilities despite the civil war). The concern in financial
markets may be more about the potential endgame if the unrest spreads
to Saudi Arabia. But the increase in oil prices is happening well before
such a drama actually plays out, and before any serious disruption to
global supply.
It is therefore likely that the rapid increases in oil price and the associated
price volatility over the past year in particular, are largely driven
by purely financial activity. This is very similar to the effects of financial
speculation on other commodity markets such as food items. The volume
of trading in crude oil futures contracts has expanded dramatically over
the past decade. As noted by Robert Pollin and James Heintz (''How speculation
is affecting gasoline prices today'', Americans for Financial Reform mimeo,
July 2011), the overall level of futures market trading of crude oil contracts
on the New York Mercantile Exchange is currently 400 percent greater than
it was in 2001, and 60 percent higher than it was two years ago. Even
relative to the increases in the physical production of global oil supplies,
trading is still 300 percent greater today than it was in 2001, and 33
percent greater than two years previously.
The ratio of ''open interest'' contracts of NYMEX (New York Metals Exchange)
crude oil futures to total global oil production is one useful indicator
of the growing extent of speculative activity in this market. This ratio
was between 4-6 per cent in the first half of the 2000s, increased to
12 per cent in late 2006 and then to as much as 18 per cent just before
the oil price peaked in June 2008. It then fell to 13 per cent in the
middle of 2008, as oil prices fell. It has been mostly rising since then,
with average levels of 16 per cent in the past few months. Large traders
in particular show growing volumes of ''long'' positions that anticipate
future price increases. (Data from Commodity Futures Trading Commission
website www.cftc.gov accessed 6 July
2011).
While this explains some of the recent volatility witnessed in oil prices,
there are some other more puzzling features of the recent price increases.
Earlier, the three major forms of crude petroleum in the global market
– Brent Crude, West Texas Intermediate and Dubai crude – generally showed
similar if not identical prices. If anything, the price of West Texas
Intermediate oil used to be slightly higher because of perceived better
quality and lower sulphur content.
However, in the very recent past the prices have diverged, and as Chart
2 shows, West Texas Intermediate is now the lowest of the three prices.
By the middle of June the difference was more than $22 per barrel. It
is not fully clear what is causing this deviation, especially the increasing
extent of it. But it is also true that futures market activity is greater
for both Brent and Dubai crude oil.
We all know who loses from rising oil prices: most of us. Oil prices
directly and indirectly enter into all other prices, through higher fuel
costs of production and transport. Agriculture is directly affected, so
food prices will definitely rise further with this oil price increase,
worsening the resurgent food crisis. Such cost pressures have another
consequence: they push governments to inflation control measures, such
as higher interest rates. In many countries this worsens the chances for
the already fragile economic recovery after the crisis. So people across
the world face lower real incomes and may face reduced employment opportunities.
Oil-importing developing countries tend to get hit much worse than other
oil importers. First, the energy-intensity of output is still much higher
(twice on average) than production in OECD countries. Second, developing
countries are often more foreign exchange-constrained and so high oil
import bills lead to balance of payments difficulties. The poorest countries
are usually the worst affected, and within developing countries poorer
groups take the brunt of the impact in higher costs of living and lower
wage prospects.
So the doubling of the oil price that we have seen in the past year has
already destroyed any positive effects of foreign aid that oil-importing
developing countries receive. Since it is also linked to global food prices
the negative effects are compounded for food importing countries. During
the last such price peak in 2008, there were calls for compensatory financing
to be provided to oil and food importers by the IMF. This never came about,
but this time round we have not even heard such noises, certainly not
loudly enough.
Who gains from the rising oil prices? The conventional approach is to
look at the countries that are major oil exporters, and somehow assume
that they are the beneficiaries of such price spikes, and that this leads
to a redistribution of global income away from oil-importing to oil-exporting
countries. This approach is reinforced by the media, which keeps emphasising
the windfall gains of governments in oil exporting countries.
But this misses the point. The really big gainers – accounting for the
largest portion of the gains by far – are the big oil companies. In fact,
big oil, which suffered a setback during the Great Recession, is back
with a bang, riding on the back of the recovery in petroleum prices in
2010. The major oil companies that announced their results in January
2011 reported a doubling of profits in 2010 compared to the previous year.
The three big US companies ExxonMobil, Chevron and ConocoPhillips together
had nearly $60 billion profits after all costs and taxes. The profits
of the Anglo-Dutch company Royal Dutch Shell also doubled, even though
production was lower than expected.
Why do profits of big oil companies increase so much during periods of
high or rising oil prices? Basically, the costs per barrel of the companies
reflect their historical costs of drilling, exploration and/or purchase
of crude oil, which often have little or nothing to do with current crude
prices. But they are quick to pass on current crude oil prices to consumers
in the form of higher prices for their products. By contrast, they tend
to be much more lethargic about passing on lower crude prices in the form
of lower prices of processed oil. So increases in crude oil prices lead
to enormous windfall gains for these companies.
In the current price surge, therefore, the real (and maybe only) gainers
are financial speculators in oil futures markets and the big oil companies
that can pass on much more than their own costs in the form of much higher
prices due to the general sense of frenzy in oil markets. So the case
for immediate and substantial taxes on the windfall oil profits of multinational
companies is very compelling. And so is the case for much more far-reaching
and effective regulation and control of the speculative activity in oil
futures and other commodity markets that is currently causing so much
collateral damage.